Cross border flows, with a bit of macroeconomics

The May surprise in the TIC data: foreign central banks withdrew financing from the US. The sold more Treasuries (14.3b) than they bought Agencies and corporate debt. Net central bank flows into long-term debt were a negative $1.4b. The reason: Norway. Norway – presumably its oil fund – sold $11.77b in Treasuries in May.

The other surprises: relatively strong outflows from the US continued in May, though US investors bought foreign bonds ($14.3b) rather than equities ($4.9b, down from an average of around $10b for the past few months); and private investors abroad suddenly rediscovered the joy of holding Treasuries. After several months of muted purchases, they bought $27.5b in May.

On the other hand, I am increasingly frustrated with the TIC data, since it rather clearly isn’t picking up much of what is going on in the world

The big problem: the folks who have money and who must be doing the buying just aren’t showing up in the data.

That’s true on several levels. A set of central banks I track added $90b to their reserves in May. China and Russia added around $50b between them. A bit of that was valuation, but not most of it. Yet even after netting out Norway, official inflows only totaled a positive 10.4b. That’s only 20% of China and Russian headline reserve growth, and an even smaller share of my estimate of global reserve growth. And the difference isn’t showing up in the short-term data. Chinese short-term claims are up $0.7b but Russian short-term claims are down $1.6b.

The Bank of Japan seems to be moving out of Treasuries into Agencies. But recorded inflows from Japan consistently have seemed small relative to Japan’s current account surplus. This month isn’t a particularly good example: Japan bought $1.7b of Treasuries, $8.7b of Agencies and $0.3b of US corporate debt, for total purchases of around $10.7b. Q1 is a better case. In the first quarter, Japan sold $19.1b of Treasuries, bought $10.9b of agencies and bought 2.3b of corporate debt, for a new flow of negative $5.9b (data is in the Treasury Bulletin). That from a big surplus country.

China shows up in the data in the expected way. But on a scale that is a bit too small. In May, China bought $0.9b of l-term Treasuries, increased its short-term Treasury holdings by $2b (largely by running down its bank deposits), bought $4.4b of Agencies and $2b of corporate debt. The net inflow was (ballpark) around $9.3b. That is still small relative to its $30b headline reserve growth in May – most of which didn’t come from valuation gains.

I don’t necessarily think the IMF should tell countries how much social spending is right – that strikes me as a national policy choice. But social spending generally should be financed out of current taxes, not future borrowing. And it is the IMF’s role to highlight the risks associated with large balance of payments deficits, particularly if that deficit reflects a big budget deficit and is increasingly financed by households borrowing in foreign currency (See Lex) … The IMF should highlight the risks of balance sheet mismatches every bit as much as risk from too much spending.

Mohsin Khan of the IMF also gave the countries of the Middle East a green card to spend a bit more a few weeks ago:

"What we want them to do is go ahead and spend money on infrastructure, the social sector and help the private sector to create jobs, and that will help in the global imbalances and the world economy," says Mohsin Khan, director of the Middle East and Central Asia department at the IMF.

That too was the right call – though it shouldn’t really be a hard call (despite what Standard Chartered says). With oil now approaching $80 and futures markets predicting that oil will remain high, most oil exporters probably don’t need to budget for $20 to $25 oil … and stock away the difference in offshore government savings accounts.

If oil exporting countries export around 40 mbd, and on average get $70 a barrel for their (exported) oil and spend around $30 – more than most are budgeting for now — simple arithmetic suggests their combined current account surplus will still be around $600 billion. They ran a trade surplus of $450b in 2005, and oil is a wee bit higher now.

Credit should be given where credit is due. I have a few quibbles with the lead of Andrews’ article. Even if it sets up a compare and contrast, I never like anything that starts with “It was enough to make a supply-side, tax-cutting Republican beam with pride.” But Andrews’ conclusion is absolutely right.

But the real news is not that tax revenues are particularly high; they are not. The big change is that tax revenues have become more of a crapshoot — more volatile, more unpredictable and more buffeted by swings in the stock market than they were 10 years ago.

Why? Because tax revenues are increasingly dependent on the fortunes of the very rich.

And it turns out that the rich are different from most other taxpayers. Much more of their income is tied, not to wages and salaries, but to the stock market and to executive bonuses, which can swing widely from year to year.

Andrews’ graph brilliantly shows how the errors in the government’s revenue forecast have been increasing, with stronger than expected revenue growth in good times and worse than expected performance in bad times. Plot this against the stock market (and perhaps an index of returns on various bond market strategies of hedge funds) and I think it becomes fairly clear that the performance of the market, not just the performance of the economy, increasingly drives tax revenues.

In today’s Wall Street JournalIp and Solomon nicely describe the political debate that has developed over the recent surge in revenues. Is it evidence that supply side incentives work, and that the rich are working harder? Or evidence that marginal tax rates for the well-to-do remain high enough to keep the tax code progressive, and thus the US government still benefits when changes in the domestic and global economy allow the already well-to-do to capture the lion’s share of the fruits of the expansion? In the first case, marginal tax rates for the well-to-do need to be cut further to induce more work and more growth and more tax revenues; in the second, case, cutting marginal tax rates on those getting all the gains from the expansion just means much lower revenues …

Andrew Rozanov – a senior manager in the official institutions group of State Street Global Advisors – thinks America’s creditors in Asia and the oil producing world should create a club (sort of like the Paris Club) to protect their interest.

He argues that Russia, the Gulf, China and others with tons of reserves and funds in oil investment funds – the savings glut nations, in Rozanov’s terminology — share two common interests:

Making sure that G-7 countries (particularly the US) pursue macroeconomic policies that protect the value of the savings glut countries’ investment in the G-7;

Making sure that the G-7 countries (particularly the US) don’t try to keep their creditors from buying the assets the creditors want to own.

“As large owners and prospective buyers of financial claims and real assets in G7 countries, creditor nations have a common interest in making sure that the G7 nations pursue sounds and sensible policies to secure their value and quality. For example, any actions by debtor nations to suddenly and severely limit foreign ownership of certain “strategic” industries or to inflate away large overseas liabilities would be a natural subject for concern and discussions in such forum.”

I actually think the issue is not whether debtor like the US nations will "suddenly" limit foreign ownership of certain industries. They already have. Ask CNOOC and Dubai Ports World. If anyone in China or the Middle East thinks that their debt holdings can realistically be traded for “real” assets on a big scale, they are smoking something.The US has never promised its creditors that it will:

Direct its macroeconomic policies to preserving the value of the dollar. The Fed actually has made it clear that it is the one thing it won’t do.

Allow its current crop of creditors to exchange their holdings of US debt for ownership of US companies on a massive scale.

Rubin doesn’t seem to be in Steve Roach’s camp. He thinks China’s peg and the resulting reserve accumulation has something to do with the US current account deficit.

Rubin: … I surely never thought, if you have the kinds of imbalances you have today, you'd have the kinds of exchange rates we have today … . To put it differently, I never thought in the face of very substantial trade imbalances, you would have inflexible exchange rates. I don't think that was part of anybody's anticipation. Another thing I don't think anyone anticipated, though it's a related thing, is that you would have these very large influxes of capital, which is what's happening in this decade–it didn't happen in the '90s–that were designed to support the dollar in order to subsidize exports [from China and other Asian nations].

So all of that has occurred. I don't think I expected the exchange rate system to work that way–I don't think anybody did. If they did, I never heard anybody say it.

Greider: Well, leave aside what people thought…. We've now got a situation that you yourself describe as quite serious in both trade and current-account deficits.

Rubin: Yep.

Greider: Does that suggest something else should have happened in the design running up to the current situation?

The latest Chinese macro news summary from Market News International pretty much says it all – nothing much has changed. The RMB floats between 7.990 and 7.999. Exports grow faster than imports. And investment growth continues to be stupendous.

**The yuan ended at 7.9926 to the dollar on the exchange-traded market, against yesterday's close of 7.9910, traders said. The central bank set a central parity rate of 7.9948 to the dollar before the start of trading today, compared with yesterday's 7.9916.

**China's GDP climbed 10.9 pct year-on-year in the second quarter, the official Securities Times reported. China's CPI rose 1.5 pct year-on-year in June, while PPI was up 3.4 pct year-on-year in the same month. Fixed asset investment in the first half rose 31.3 pct year-on-year, and it rose about 35 pct for June alone. The industrial value-added output in June gained 19.5 pct year-on-year.

It sure seems like China is unwilling to even try to make use of standard macroeconomic tools to help cool the economy. The maximum policy measures under consideration under Beijing – whether higher interest rates or a bit more appreciation in the RMB – are far too small to make a difference. Say China lets the RMB appreciate by 2% rather than the 1% of the first half of the. The total move would perhaps make up for inflation differentials between China and the US. And the RMB would still depreciate in real terms.

With oil at $75 plus again and concerns that events are spiraling out of control in the Middle East, the world seems to be changing far faster than Chinese policy.

Should China’s investment bubble burst (30% y/y growth in fixed asset investment has to be discounted to get the number in the national accounts, but it is still very fast growth), China won’t have anyone to blame but itself. It sure won’t burst because the exchange rate has been allowed to appreciate too fast.

And it may end up bursting because China continues to miss opportunities to make use of standard instruments of macroeconomic control – higher interest rates, a stronger exchange rate – too cool an economy that sure looks to have grown an extraordinarily fast clip in the first half of 2006. Perhaps even faster than the official estimate.

Jeremey Peters' New York Times article on the trade deficit says that there is no sign that the US demand for oil imports is slowing. The evidence: oil imports, in millions of barrels per day, are as high as they have been since October.

I disagree. The evidence that higher prices are restraining demand for imported oil – both by encouraging marginal supply in the US to come on line and reducing US demand – is pretty good. I like looking at the import volume series reported in exhibit 17 of the trade report. Those volumes grew by 7.3% in 2003 (v 2002), 5.7% in 2004, 1.7% in 2005 and are down 2% so far this year (v. the first five months of 2005).

Up until the recent surge in oil prices, oil imports were growing faster than overall US demand for oil. Not anymore.

I am not sure if this is more a demand response (less US demand for oil) or more a supply response (more domestic US production), but it seems like pretty clear evidence to me. My forecasts for the 2006 trade deficit now incorporate a baseline without any increase in demand for imported oil. I probably should work in a small fall.

Incidentally, Chinese demand for oil is up 15% y/y. Probably because new car sales have been growing like mad. It probably isn’t an accident that in the face of growing Chinese demand and limited growth in supply, higher prices have helped to push US demand down. That’s how markets work. They match demand and supply.

I also wanted to build on a couple of points that I made yesterday — points that put me outside the emerging consensus (see the various investment bank daily comments) that the non-oil trade deficit may have peaked. My worry: folks are extrapolating on the basis of recent trends on the non-oil import and export side that may not be sustained.

The following chart shows US non-oil imports. They basically have been flat since January. Interestingly, they also were flat in the first half of last year, then grew strongly in the second half. That supposedly was linked to a correction in electronics inventories, among other things.

The basic story in the May data is that nothing much has changed, other than the oil price.

And that in some sense is good news.

Export growth continues at a quite nice clip. Thank you Boeing. Aircraft exports in May were $0.7b more than in April (updated, initially I said 0.5b — bad rounding). And for the year, exports are up $5b – or about $1 b a month on average.

The oil import bill continues to rise. Almost all because of higher prices. The average cost of imported crude was $61.75 in May. Oil import volume in May were a bit higher than in May last year, but in the broader sense of things, volume growth remains subdued. For the first five months of 06, overall “energy related petroleum products” import volumes are down 2% (Exhibit 17).

And non-oil imports have basically been flat all year. May was no exception. Indeed, non-oil imports in May look to be down every so slightly from earlier in the year. Non-oil goods and services imports have been around $155b all year. Non-oil goods imports have been around $127b. January was higher. February was lower (Chinese new year). And May was a bit lower. I was going to try to add in a graph, but Calculated Risk beat me to it.

On the import side, the US economy has already slowed. Though that may be, in part, a reaction to the very fast increase in imports in q4.

Looking ahead, I expect some slowdown in export growth. The first five months have been very, very strong. Take whatever measure you like of exports (y/y increase in three month moving average, increase in first five months of this year over last year, May 06 over May 05). It shows something like 12% y/y igrowth. For that to continue, exports would need to average $123.2b in the fourth quarter – up from 118.7b in May and $116b in April and March. That is possible, but there are some risks that export growth may slow down a bit later in the year.

And I wouldn’t expect non-oil imports to remain totally flat if the US economy continues to grow. Some pick up – say to $160b a month by the fourth quarter – is to be expected even if the economy does slow.

China flirted with the radical step of letting its exchange rate rise to …. 7.987 on Monday. but apparently that was too much. Yesterday, the exchange rate closed at 7.991, back in the PBoC’s comfort range.

This year, the RMB has appreciated by maybe 1% against the dollar – and fallen by a lot more against the euro. In the meantime, China’s trade surplus continues to surge. It reached $14.5b in June, powered by a 25% increase in exports (y/y).

China’s first half trade surplus is about 50% bigger than its surplus in the first half of 2005, which itself was considered quite large. Assume that holds for the year. China’s trade surplus (with the world) would rise to $150b or so, up $50b from 2005. Its current account surplus would be even bigger – perhaps $200b. All that interest income on China’s $1 trillion in reserves! I will though concede there is something a bit strange with China’s current account number, since some of the income surplus should be offset by profits on foreign FDI in China.

What of the other big Asian surplus country – Japan. Is the resurgence in domestic demand leading Japan’s trade surplus to fall? Uh no. Its May trade surplus was up substantially from a year ago. And with the interest income on Japan’s massive holdings on Treasuries rising, its current account surplus should be growing too.

The impact of the resurgence of Japanese growth on the US trade balance strikes me as massively overstated. Japan has a big economy. But it doesn’t import that many manufactured goods, as least not relative to its GDP. And most of the goods that it does import don’t come from the US. You need an awfully big elasticity for 2% Japanese growth to generate a huge surge in the dollar value of US exports to Japan (around $55b in 2005). Particularly with the yen very weak in real terms. Japan needs to grow with a strong yen — not grow with a weak yen — to contribute to global rebalancing.

The rest of developing Asia — counting India — actually doesn’t have much of a surplus anymore. And Korea's surplus is falling. Oil imports. (Edited for greater precision)

Indeed, Bill Pesek makes a point that Americans who argue that since the US can never compete with cheap Chinese labor, it should therefore want China to keep its exchange rate low to keep the cost of US imports from China down might want to consider.

The main reason [for the smaller than expected deficit] is a big spike in corporate tax receipts, which have nearly tripled since 2003, as well as what appears to be a big rise in individual taxes on stock market profits and executive bonuses. ….

Corporate tax payments are expected to exceed $300 billion, up from $131 billion three years ago. The other big increase is an extraordinary jump in individual taxes that were not withheld from paychecks, usually a reflection of taxes on investment income and executive bonuses.

Though I am pretty sure executives wouldn't pay taxes on their bonuses if the Club for Growth had its way. It is also ironic – at least to me – that the corporate income tax is bailing out the Bush Administration. Particularly since Paul O’Neill wanted to abolish it. Double-taxation, you know.

As DeLong notes, Andrews over-states the amount of good news by accepting the Administration's inflated baseline forecast. But he also highlights one issue that I think deserves a bit more attention.

Tax revenues increasingly are a function of stock market moves, which influence things like amount of income CEOs get from exercising their options. That seems likely to be one reason why tax revenue volatility has increased over the past decade.

Over the past decade, tax revenues have become much more volatile, alternately soaring and plunging in the wake of swings in the stock market and repeatedly defying government projections.

Worth remembering. Some of the gains that the US is now enjoying may prove rather ephemeral.

New Independent Task Force Reports

India now matters to U.S. interests in virtually every dimension. This Independent Task Force report assesses the current situation in India and the U.S.-India relationship, and suggests a new model for partnership with a rising India.

Rates of heart disease, cancer, diabetes, and other noncommunicable diseases (NCDs) in low- and middle-income countries are increasing faster than in wealthier countries. The report outlines a plan for collective action on this growing epidemic.

The authors argue that the United States has responded inadequately to the rise of Chinese power and recommend placing less strategic emphasis on the goal of integrating China into the international system and more on balancing China's rise.

Campbell evaluates the implications of the Boko Haram insurgency and recommends that the United States support Nigerian efforts to address the drivers of Boko Haram, such as poverty and corruption, and to foster stronger ties with Nigerian civil society.